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Housing market could create a catch-22 for the ECB

Deutsche Bank Research Management
Stefan Schneider

Fighting inflation is high on the ECB’s agenda. If inflation remains elevated, additional rate increases could pose challenges in the housing markets. Given their size and importance, this would likely have ramifications for macro-financial stability.

In the boom years, investments in many German cities offered a net rental yield of roughly 3%, which was financed by a mortgage rate of 1%. This offered positive cash flow. Investors could easily leverage it to earn double-digit returns. Now, with mortgage rates clearly above 3%, the tide has turned. Let us assume 4% financing costs. If rents cannot be raised in the short run, prices will have to drop by 25% to raise rental yields back to break-even. Of course, even more substantial price drops will be necessary if investors expect positive cash flow.
We already anticipated in spring 2021 that the housing boom in Germany would come to an end, expecting a modest market correction, discussing the risk of an interest rate shock, and often mentioning the advantages of available hedging instruments. Unfortunately, we were still surprised by the steepness of the interest rate hikes that have occurred since December 2021. Until recently, investors had been willing to accept our bull case of an only-modest market correction. We still think that negative real short rates, historical inflation protection through residential property, substantial supply shortage, and rising rental growth are important factors that should stabilize prices soon. A price dip remains our base case. But this view requires an early stopping of rate hikes.
2022 Euro area countries: Price-to-income ratio
Sources: Deutsche Bank Research, OECD
Money markets have already priced in additional rate hikes and even assume terminal rates above 4%. We expect a terminal rate of 3.75%. So far, most investors have been able to cope with the new environment. Long maturities, fixed rates, hedging, and big profits resulted in investors being in a comfortable position to digest losses they may be seeing now. However, some investors – especially the highly successful ones in the boom years, who have leverage that is sometimes above 100%, variable rates, and no hedging – are experiencing difficulties. They face both falling prices and negative cash flow as returns are below refinancing costs.
Recently, central bankers have indicated that inflation is stickier than previously thought; some have even surprised with very hawkish statements. We think further rate hikes will be difficult to swallow without hiccups in the property market or even a fuller-blown crisis. For more than a decade, we have disagreed that the strongly rising property prices marked a housing bubble in Germany. We stick to this assessment. But other countries might be more vulnerable. Low interest rates had propelled prices in nearly all euro-area countries to recent all-time highs.
2022 Euro area countries: Price-to-rent ratio
Sources: Deutsche Bank Research, OECD
Moreover, affordability indices are often elevated, particularly in core countries. The OECD provides data for 11 countries in the euro area with data back to the 1970s. The historical average of price-to-income and price-to-rent ratios is set to 100 for each country. Several indices are above the 95-percentile mark of the full history of all 11 countries. The Netherlands has a price-to-income ratio – a very important affordability index – of 159.9, a new all-time high across all 11 countries. The risk of a housing market crash or at least a serious correction in certain countries of the euro area will rise if the ECB acts in accordance with some of the recent hawkish statements. If our assessment is correct, then the trade-off between fighting inflation and avoiding macro-financial instability will become a key topic for the ECB.

German translation published on March 13, 2023: ˮDer Häusermarkt könnte die EZB in eine Zwickmühle bringenˮ

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